Behind the mysterious disappearance of a $ 1.7 billion mutual fund

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The Infinity Q Diversified Alpha fund disclosed in filings with the Securities and Exchange Commission valuations of investments that, in at least three cases, were incorrect or inconsistent with market conditions, traders and academics said. An assessment was mathematically impossible, said a former Morgan Stanley chief executive who reviewed the disclosures.

In one case, the disclosures show that Infinity entered into two nearly identical swap contracts referencing the same index during the same time period, while recording a gain on one that was more than three times greater than the other. – a result according to analysts which defies logic. Swaps are bilateral contracts, negotiated by banks, that traders use to bet on asset prices, interest rates, or other financial trends.

In February, the company made the unusual decision to stop investor buybacks and say it could no longer value its holdings. At least two people have raised concerns about the fund to the SEC, and it is under investigation by the regulator, people familiar with the matter said.

The SEC informed Infinity of the evidence that the company’s chief investment officer, James Velissaris, was adjusting the parameters of third-party pricing models used to value its derivatives, leaving Infinity unable to accurately value its holdings, the company said.

Infinity also said it banned Mr Velissaris from trading, placed him on administrative leave and was reassessing previous valuations before returning money to investors.

The Federal Bureau of Investigation and prosecutors from the Manhattan U.S. Attorney’s Office are also investigating, people familiar with the matter said.

A spokesperson for Infinity and Wildcat Capital Management, a family office affiliated with the company, said they “are both working in cooperation with the SEC and all other government agencies and supporting the steps being taken to maximize profits. returns for investors ”.

Mr. Velissaris declined to be questioned through his spokesperson. Sean Hecker, Mr Velissaris’ attorney, said two of the false evaluations described by the Journal were “clerical errors” which had been corrected and that Mr Velissaris had made efforts “to act in the best interest investors ”.

The Journal polled half a dozen equity derivatives traders and academics who reviewed Infinity’s positions as published in regular disclosures with the SEC. These interviews and the Journal’s analysis of the fund’s portfolio revealed deviations from usual practice in the way certain investments are generally valued.

The mutual fund, which was launched in 2014 and is part of Infinity Q Capital Management LLC, sought to generate returns that were not as tied to the returns of other assets like stocks and bonds, according to its information. A family office investor said the company views the mutual fund as a hedge for its holdings.

It seemed to be paying off, especially during last year’s selling shock. In March 2020, the mutual fund posted a return of around 7%, while the S&P 500 fell 12.4%, its worst month since 2008. That month, the fund attracted its lowest inflows. highest ever, according to Morningstar Direct data.

Infinity attracted over $ 1 billion in revenue last year and bragged about its affiliation with Wildcat, which is the family office of David Bonderman, the founding partner of private equity giant TPG. A now archived version of Infinity’s website indicates that Infinity Q Capital Management was “managed by David Bonderman’s family office.”

A spokesperson for Wildcat – who also represents Infinity Q – said the company “was shocked and disappointed to learn of the SEC’s allegations” related to Mr. Velissaris, and that Infinity Q “was majority owned and controlled by Mr. Velissaris. Bonderman family investment vehicles have only been passive investors in Infinity Q Capital Management. “

Mr Bonderman declined to comment through a spokesperson.

Infinity has taken positions in stocks, currencies and other assets across all markets, but analysts trying to figure out what went wrong have focused on its use of complex Wall Street products, including those known as variance swaps. They allow investors to bet that price movements in indices like the S&P 500 will exceed or fall below a fixed amount over a period of time. Swaps can be customized by users, such as investors and the banks they trade with, to make a pure bet on a specific outcome.

The nature of the swaps and Infinity’s disclosures with the SEC help determine how some of the investments were valued, traders and academics have said, and whether those valuations were appropriate. In some cases, they said, it seems not.

Take the case of a swap sold by Infinity Q linked to the MSCI World Index, according to its information released in February 2020. Investors often sell swaps to bet that volatility will decrease.

Traders and analysts evaluated the size of the position – which was expected to gain around $ 600,000 for a slight drop in volatility – and what is known as the strike, or the level of volatility the bet is tied to. In this case, that number was 17.3%, according to the Infinity revelations.

On February 29, 2020, Infinity’s filing showed a gain on the position of $ 5.6 million.

But given the terms set out, the maximum Infinity could hope to make on the trade would be $ 5.2 million, according to Peter Carr, former managing director of Morgan Stanley and chairman of the finance and risk engineering department. from New York University Tandon School of Engineering. . This would be the gain if the volatility drops to zero.

Such a drop would be rare: volatility has not fallen to zero in the S&P 500 since its inception in 1957.

“There is no justification for this gain,” said Carr, who helped write formulas for valuing variance swaps and followed them for more than two decades. He reviewed the position and said winning was mathematically impossible.

A few months later, in May 2020, Infinity Q revealed that it held two nearly identical swaps linked to the Russell 2000 Index. As a buyer, Infinity Q was betting that the volatility of the Russell Index would exceed 22.4% in one. case and 22.8% in another, over an identical period of 12 months.

The swap with the lowest 22.4% hurdle was a bit more aggressive, putting about $ 250,000 at risk for a slight change in volatility, compared to about $ 150,000 at risk for the swap with the hurdle. The highest. Infinity’s earnings increased exponentially as volatility broke through these thresholds.

Still, the fund’s gains on the first trade were more than three times greater than on the second, a divergence academics deemed too large to be accounted for by position size or other variables. declared. One showed a gain of about $ 13 million and the other a gain of $ 4.1 million.

“These two gains cannot be correct,” Carr said. He said at least one of the data used was wrong: Infinity should have used the same entry for the expected Russell volatility for both swaps. This means that the valuation on at least one of the swaps was incorrect, he said.

Mr Hecker said that “the two examples provided to us involve clerical errors which have already been identified, corrected and reported”.

There are other quirks in the company’s disclosures. Paul Staneski, founder of consulting firm Derivatives Solutions, says the firm’s variance swap portfolio appeared to be tens of millions of dollars overvalued in May 2020.

The prices used by the fund “were exceptionally favorable and did not correspond to the market situation,” Staneski said. [volatility] that anyone reports. “

To be sure, volatility expectations may differ between different banks providing quotes to customers and data providers, Mr Staneski said. But for some swaps, the volatility expected at the time should have been outside the range of normal expectations, he said.

In another case last May, Infinity revealed that it sold a variance swap linked to the S&P 500, a bet that would benefit if volatility declined until the end of the year. Instead, volatility skyrocketed as the Covid-19 pandemic spread across the United States and hammered the markets.

Infinity disclosed a loss of around $ 5 million at the end of May. But volatility had jumped so much – the Cboe volatility index climbed to 37 that month, from around 16 in early February, when the swap took effect – that Infinity was likely sitting on a loss of about three times that. there Mr. Staneski and other traders said. Shortly after the swap went into effect on February 4, the 11-year S&P 500 bull market came to a screeching halt.

Mr Hecker said that “Bloomberg’s interactive pricing tool is designed to be used interactively by users to make reasonable estimates of asset valuations, and any investigation will determine that James used these tools and ‘others to determine appropriate valuations as part of its efforts to act in the best interests of investors. “

Investors say they expect big losses. Infinity recently valued its holdings at around $ 1.2 billion, about 28% below the $ 1.7 billion disclosed on February 18, the last day it calculated a net asset value.

The company said in an investor update that the plunging value of its holdings came mainly from over-the-counter transactions – including variance swaps and other swaps and options – it had with a range of banks. Complex positions such as swaps accounted for nearly a fifth of the company’s value in February, before it began to liquidate, the company said.

Mr Hecker said the latest valuation “reflects distressed liquidation stocks that were affected by the fund’s default during the liquidation process.”

It’s unclear how much investors could ultimately recover after legal fees. An investor in the fund brought a class action lawsuit against the company, alleging that it had made misleading statements about its business and financial results, and that the executives intended to mislead investors. The Infinity spokesperson declined to comment on the pending litigation.

Infinity is expected to present a fund distribution plan to investors by May 24.

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